Capital Structure, Equity Capital, Debt Capital, and Other Types of Capital - Literature review Example

Capital Structure Name Institution Date Abstract This assessment was aimed at critically reflecting of corporate finance concepts with special reference to capital structure by reviewing the existing literature. Capital structure was described on the basis of modern thinking of the Modigliani Miller theory that supports a capital structure in a perfect market whereby capital structure is irrelevant. This modern thinking is capital structure was critically objected by other theories that support capital structure in the real world whereby capital structure is relevant. The theories discussed in this assessment that support the relevance of capital structure include; the pecking order theory, the trade-off theory and the agency costs theory. The main gap that was established in the literature is how firms seek to achieve the optimal capital structure that ensures maximum benefits are achieved in the business. The assessment also described different methods of financing a business including; equity financing, debt financing and other sources of capital such as vendor financing. Equity capital is the money owned and put up by the owners of a firm or the shareholders. Debt capital is that money which is borrowed and is at work within the business. Vendor financing is whereby a firm has the capability of selling the goods before making payments to the vendor. The literature review finalised with a conclusion. Capital Structure Introduction Capital structure means the different sources of finances of a firm that are used for the purpose of financing the overall operations as well as growth (Titman & Wessels 1). It is the combination of long term debt, common equity, specific short term debt as well as preferred equity of an organisation. This assessment aims at critically reflecting of corporate finance concepts with special reference to capital structure by reviewing the existing literature. In capital structure, debt arises in the type of long term notes payable or bond issues while equity arises in the type of retained earnings, common stock as well as preferred stock. Short term debt arises in the type of working capital requirements and forms a part of capital structure (Rajan & Zingales, 1421). According to Harris & Raviv (293), it is important to study capital structure because it enables a firm analyse the proportion of short term debt to that of long term debt. The ratio of debt to equity helps in proving an insight about a firm’s risky status. This means that, an organisation that is heavily financed by debt has a high probability of greater risks than that which is financed heavily equity since it is highly leveraged. Current research shows that, capital structure is concerned with ways of financing the assets of a company by combining equity, debt as well as hybrid securities (Leland 1213). The modern thinking of capital structure is based on the Modigliani Miller theory that was established by two theorists referred to as Franco Modigliani and Merton Miller. However, this theory was viewed to be a pure theoretical concept only without considering some if the factors that involve the capital structure process. The current concept and description of capital structure by Modigliani ignores many factors that are important in the capital structure process such as; fluctuations as well as situations those are uncertain and may be in occurrence within the course of funding a company. The assumption of the theory that, in a situation of a perfect market, the way in which a firm is financed has no relationship to its value is vague (Heinkel 1142). The above explanation of capital structure does not consider the capital structure in the real world whereby the value of the firm is relevant on how it is financed. This argument forms the basis of our research so as to examine reasons for the relevance of capital structure in the real world whereby, the value of a company is influenced by the capital structure that it employs. The analysis of capital structure in this perspective calls for further research on how to arrive at an optimal capital structure of a firm. An optimal capital structure is one that serves to maximise the value of the company (DeAngelo & Masulis 3). Capital structure is a corporate finance concept which is important since it influences the returns that a company makes for its shareholders. It also influences the survival of a firm during in the time of depression and recession. It is important to managers of a company that helps them in determining how much of the business capital should come from debt without putting the business in danger. The capital structure of a firm is also important to regulators because they are able to determine taxation charges and regulation of firms who depend of long term debt (Feldblum 158). The body of this assessment involves a literature review that explains various theories and concepts of capital structure including; equity capital, debt capital, other forms of capital of a business, the optimal capital structure, capital structure in a perfect market and capital structure in the real world. The literature will finalise with a conclusion. Equity Capital In the capital structure of a firm, equity capital is the money owned and put up by the owners of a firm or the shareholders. There are two types of equity capital including; retained earnings and contributed capital (Titman & Wessels, 3). DeAngelo & Masulis (5) describe that, equity capital is a type of capital which is most expensive among other types of capital of a firm. The reason is that, the cost of equity capital is that return which an organisation must earn so as to attract investment. Therefore, a firm that requires high capital investments usually need a return on equity to encourage investors in purchasing it’s stock that is higher than a firm that requires low capital investments. This can be further explained using an example of a mining company and a company that sells beauty products. A mining company requires a return of equity which is higher compared to a beauty products company. Debt Capital In the capital structure of a company, debt capital is that money which is borrowed and is at work within the business (Leland 1213). Long term bonds are considered to be the safest type of debt capital. The reason is that, the firm is considered to have many years for coming up with the principal and the meantime only paying only interest on the lump sum. Debt capital also include commercial paper which is short term and can be used by a firm to cater for day-to-day needs of working capital like payroll as well as utility bills. Harris & Raviv (322) argue that, in the capital structure, the cost of debt capital usually depends on company’s financial status as depicted in the balance sheet. Other Types of Capital The capital structure also includes other types of capital like vendor financing. Vendor financing is whereby a firm has the capability of selling the goods before making payments to the vendor. This is a way if financing that a business can use to increase its return on equity drastically. It is a safe way of financing a business since the company does not need to incur any costs to get the financing (Brennan, Maksimovic’s & Zechner 1127). This type of financing is one the secrets that a firm can use to succeed fast in business. A firm is able to sell products prior to the payment of the bills to the suppliers. The effect of vendor financing is that, the firm grows its business with the use of vendor’s money (Brennan, Maksimovic’s & Zechner 1128). It is a method of financing that is mostly applicable to insurance companies whereby the float of the policy holder is a representation of money that does not belong to the insurance business, but the firm uses and earns by investing on that money up to the time when it is required to make payments for accidents or even medical bills. In the capital structure, this type of financing is seen to vary from one case to the other based on the discipline of managers. The Optimal Capital Structure It is evident that, the cost of capital is the simple consideration that successful companies all over the world base their capital structure. How much a firm takes a debt depends on the security of the revenues that are generated from the business (Bradley Jarrell & Kim 858). For example, a firm that sells products that are indispensable with the knowledge that people must have such products, will experience a much lower risk of debt than a firm that operates a theme park within a tourist town at a market boom. Making a decision in the above situations requires managerial wisdom, talent as well as experience. Managers who are wise enough will seek to lower their weighted average cost of capital consistently. They can achieve this through the increase of productivity and looking for products with higher returns among other ways (Myers 147). Capital Structure in a Perfect Market According to Kraus & Litzenberger (913), a perfect market is one that does not involve transactions and bankruptcy costs. There is perfect information whereby firms as well as individuals have the capacity to borrow while relying on a constant interest rate, there are no tax charges and returns on investment are not influenced by financial uncertainty. The capital structure in a perfect market was described by Modigliani and Miller who came up with two findings based on the above conditions. The findings include; there is no relationship that exists between the value of a firm and its capital structure, the cost of equity for both leveraged and unleveraged firm are equal and includes an additional premium for financial risk (Kraus & Litzenberger 914). This means that, the increase of leverage leads to a shift of risk between classes of investors that are different, with a constant total firm risk. Hence, there is no additional creation of value. The analysis of capital structure in a perfect market was also based on the influence of taxes as well as risky debt (Modigliani & Miller 435). In such a consideration, it is important to note that, the deductibility of interest on tax has an effect of making the debt financing valuable under a classical tax system. This means that, the increase of debt within the capital structure has a decreasing effect on the cost of capital. Hence, the optimal capital structure in a perfect market does not include equity financing; it consists of a hundred per cent debt financing (Kim 48). Capital Structure in the Real World The assumption of capital structure in the real world is that, in a perfect market, the capital structure is not relevant; therefore, imperfections that exist in the real world make the capital structure to be relevant. The imperfections that exist in the real world were described by various theories that did not consider the assumptions that were made by Modigliani and Miller in their model of capital structure. Trade off Theory In the trade off theory, bankruptcy costs are allowed to exist. This theory states that, debt financing has an advantage for a firm since a business gains through tax benefits that arise from debt (Shyam-Sunder & Myers 219). It also states that, debt financing has a disadvantage of costs that are incurred by the firm as a result of debt. Such costs of debt include; bankruptcy costs as well as costs of financial distress. Bradley, M., Jarrell, G. A., & Kim (859) argue that, a trade-off is realised when the marginal benefit of debt decreases with the increase in debt and an increase in marginal cost. Therefore, a firm that has an objective of overall value optimisation focuses on this trade-off when making a decision on how much debt as well as equity should be used for the purpose of financing the company. Flannery & Rangan (472) denote that, this is an important theory that can be used to make an explanation of differences that exist in debt to equity ratios among different industries. However, this theory cannot be used make the same explanation between firms in the same industry. Pecking Order Theory The pecking order theory aims at capturing the costs of information which is asymmetric. This theory states that, firms make prioritization of sourcing their finances both internal financing as well as equity based on the law of least effort, or the law of least resistance, making a preference to raise equity as a means of sourcing finances of last resort (Jensen & Meckling 305). Considering the assumptions of the pecking order theory, firms usually make use of internal financing first after which they utilise debt issue. When the issue of debt is not sensible any longer, the last resort of financing is equity. According to this theory, a company adheres to a financing sources hierarchy with internal financing being the most preferable method of financing as long as it is available. In this theory, debt financing is more preferred to equity financing when the firm needs external financing. The reason is that, equity financing would mean that, the firm will be required to issue shares that encourage external ownership into the company. According to Myers (187), equity financing is less preferred as a means of financing a company. The reason is that, when managers in a firm make an issue of new equity, investors have a notion that, manager’s think in terms of an overvaluation of the firm and thereby taking advantage of the overvaluation. This notion by investors is because, managers are assumed to have a better knowledge of the true status of the company as compared to investors. As a result, investors usually place a value which is low to the issuance of the new equity. Agency Costs Agency costs can also be used to explain the capital structure relevance in the real world (Leland 1215). Types of agency costs include; asset substitution effect, under investment problem also known as debt overhang problem as well as free cash flow. The asset substitution effect denotes that, the increase in debt to equity ratio, increases management incentive in undertaking projects that are risky. The reason is that, managers expects the project to be successful and will be of benefit to shareholders. On the other side, when the project is unsuccessful, debt holders face the risk. The underinvestment problem denotes that, a debt which is risky for the growth of the firm, the gains that will be accrued from the project will go to debt holders instead of shareholders. Therefore, it is the duty of the management to make a decision of rejecting projects with positive net present value, even if these projects have the potential of increasing the firm value. The free cash flow denote that, not unless the free cash flow is returned back to the investors of the company, managers in the business have the duty to make a decision of destroying the value of the firm by building an empire as well as perks. Leverage increase is viewed to impose discipline in financing to the management (Leland 1217). Conclusion The capital structure of a firm involves both equity and debt financing. A company is required to determine which of the two methods of financing a business is more favourable to adopt. The finance concept of capital structure is clearly demonstrated in this report. Equity capital in an organisation is sourced from retained earnings as well as contributed capital. Retained earnings are the profits that have been gained and kept by the business from the previous years. It is used for the purpose of strengthening the balance sheet or the growth of funds, acquisitions as well as expansion of the business. Contributed capital is that money which was initially invested to the business as an exchange of ownership or shares of stock. Debt capital is the money that an organisation borrows to boost business operations. The cost of debt capital is determined by the company’s financial status as depicted in the balance sheet and is an indication that, a firm with low debt financing has the capability borrowing at a low rate when compared to another company that is high in debt financing that may be required to pay extra interest for debt capital exchange. Another source of financing of an organization is vendor financing which is mostly embraced by those dealing with suppliers for sourcing products for resale. Most of the retailers are seen to embrace this type of business financing since it is convenient for them. In relation to the optimal capital structure, the report concludes that, making a decision for the optimal capital structure requires managerial wisdom, talent as well as experience so as to make the best decision. It is evident that, managers of a company who are wise enough will seek to consistently lower their weighted average cost of capital. To achieve this, they are required to increase productivity and look for products that have higher returns. The literature review also demonstrated capital structure in relation to a perfect market whereby, it is clear that, capital structure in this type of a market does not recognise the relevance of capital structure in the value of the firm. Additionally, capital structure in the real world was discussed as supporting the relevance of capital structure in the value of the firm. All in all, the capital structure of a firm should be analysed in consideration of short term as well as long term debt. The reason is that, the debt to equity ratio helps in providing information on how risky a firm is. Companies are said to be risky when they are highly dependent of debt financing. Future research needs to be done on the application of optimal capital structure in firms and how beneficial these firms have gained through the application of optimal capital structure. 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